The End of Carte Blanche Bailouts

There’s a forthcoming crisis developing. Stocks have run up over the last five years to new highs. Many find this cause for celebration…we find it cause for alarm.

Somewhere along their travels, stocks drifted out of orbit from the real economy. In short, the economy reclined while the stock market boomed. Of course, no one quite knows what’s going to happen next.

Stocks could continue to rise. They could drift sideways. Or they could slowly slide down from their highs. But like an out of control satellite we have a feeling stocks could very quickly burn up and disintegrate.

The conventional wisdom from Wall Street is that with the Fed still goosing the markets with $55 billion a month and a federal funds rate at practically zero the market will remain inflated. Prices can’t dramatically fall, goes the popular delusion. Naturally, we have some reservations.

We understand the logic and the massive put the Fed has under the market. All the cheap credit and liquidity encourages risk taking and higher stock prices. But here at the Economic Prism we also trust in gravity.

Match Stick Investing

Eventually, with all the cheap credit, the risks go from calculated, to speculative, to suicidal. Initially, share prices for profitable businesses paying out a 3 percent yield are bid up. Before long, people borrow money to place wagers on shares of Twitter.

What we mean is the Russell 2000 is currently trading at over 80 times earnings. Yet speculators are eagerly buying these lit match sticks…confident they’ll be able to pass them off to others at higher prices without getting burned. What to make of it…

“Stock prices have reached what looks like a permanently high plateau,” predicted 20th century Ph.D. economist Irving Fisher on October 17, 1929. Regrettably, what he took for a plateau was actually a peak. Within a week of Fisher’s bold prediction the stock market crashed…along with his personal wealth and academic reputation.

An epic crash may not be in the cards this time around. But there is a real possibility for one. This is especially conceivable because the march onward and upward for stocks has been driven by mass quantities of credit and debt.

In fact, according to New York Stock Exchange figures, margin debt recently hit a new high of $451 billion. The old high for margin debt was $381 billion in July 2007. Do you recall what happened soon after? The S&P 500 dropped 56.4 percent between October 9, 2007 and March 5, 2009.

The End of Carte Blanche Bailouts

You see, on the way up, debt has the marvelous effect of pushing stocks up farther and faster than they otherwise would go. However, when stocks reverse course, a cascading decline can be triggered. That’s the painful, downside of margin debt.

The excessive margin debt forces speculators to quickly sell off their borrowed shares. The feedback loop quickly becomes self-reinforcing. Before long there’s a stampede for the exits…and share prices crash.

Perhaps the Fed can keep the bubble inflated a while longer. That they’ve been able to keep it pumped up this long is already quite a feat. Nonetheless, the market will eventually cave in…it must. Then what?

The Fed’s efforts this time around never did really succeed in pumping up consumer demand. A false boom, like the housing boom of the early-to-mid-2000s, never materialized outside of the stock market. The lesson Main Street tenderly learned from the Great Recession was that, on a personal level, you can’t borrow your way to prosperity.

Unfortunately, stock market speculators don’t seem to have learned a darned thing. Once again they borrowed massive amounts of money to gamble on stocks. Their days are numbered. Soon their paper earnings will turn into real losses.

Perhaps following the next crash the American populace won’t give the Fed and Treasury the carte blanche latitude to bailout the big banks. But that doesn’t mean the rascals won’t try it. No doubt, that’ll be for the last time.